KBRA Financial Intelligence

3 Things in Credit: Economic slack, Equity euphoria, and Consumer lenders

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Welcome market participants to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

So, important meetings this week are now in the rear-view mirror, and the result is unchanged. No, I’m not talking about the FOMC’s or Bank of England’s decision to hold rates, I’m talking about Costco’s decision to hold the price of its hot dog/soda combination at $1.50, the same level since 1985. On an inflation-adjusted basis, the cost should be $4.33. A welcome and true loss leader.

One programming note. Make sure you listen in to my discussion with Craig Packer, Co-President and Head of Blue Owl Capital’s $85 billion direct lending credit Platform. It’s the latest installment in my Leading Voices in Credit podcast series. You can find it wherever you access your podcasts or on our website, KBRA.com.

This week, our 3 Things are:

1. Slack. It’s growing in the labor and industrial markets.

2. Equity euphoria. A surprising view of what’s ahead.

3. Consumer lenders. Risk investors are making a noteworthy distinction.

Alright, let’s dig a bit deeper.

Slack.

Those of you of a certain vintage will remember the “Misery Index,” the sum of inflation and the unemployment rates, created by an economist in the Johnson administration. That’s Lyndon Johnson, if you’re wondering, not Andrew. I’m not that old.

It’s kind of simple, but there’s a certain elegance in the index’s simplicity. People tend to be miserable in periods of high inflation, doubly so when the labor market falls apart. Over the past 76 years, the misery index peaked in June 1980 at 22%, about a year after President Carter’s infamous “Crisis in Confidence” speech. Lots of misery. We’re currently at 7%, nicely below the 9% long-term average, but above the 21st century low of 5% set back in 2015. Squares up nicely with a soft-landing scenario.

The Misery Index got me thinking about the other side of a soft-landing, and that is slack in the economy, something the Fed would like to see more of. Two indicators I pay attention to on that point are the underemployment rate, the U-6 in government-speak as opposed to the U-3 unemployment rate we all know and love. And then I think about capacity utilization, the monthly measure out of the Federal Reserve.

I actually did a back of the envelope “Slack Index” (the U-6 plus 1-Capacity Utilization) on this podcast a few years ago. I won’t bother with the math behind that calculation, but it is interesting to note that both the U-6, that underemployment rate, and capacity utilization are trending the wrong way. Wrong if you are looking for economic growth, but trending favorably if you are the Fed. That’s where we are seeing the labor market loosen up, and the utilization of the “installed productive capacity” of the country slow. Neither is all that worrisome, and that’s the challenge to the Fed, the needle it has to thread here—slow the economy, but don’t make it contract. So far, so good. Slack is building, and misery is subsiding. And that’s good for credit.

Alright, on to our second Thing, Equity euphoria.

Stocks continue to fly. I know, I know, it’s all AI-driven. Although, I would point out that the equal-weighted S&P is up 6.1% year to date, and even the lagging Russell 2000 is up off the mat, turning fractionally positive on the year. So it’s not just AI driving the market higher, we are seeing a broadening, no doubt driven by the soft landing narrative that has become consensus. In any event, stocks up usually means spreads tighter. And that’s clearly the case today.

So, where to from here? Fair question, and for that we turn to Street strategists. Bloomberg has compiled updated views from its control group, 19 strats, from their December 2023 forecasts. And the results are…wait for it…decidedly bearish.

From today’s level on the S&P, 14 of the 19 have the S&P falling by year-end, and 8 of the 19 come in below 5,000. The median on the S&P for the group, for what it’s worth, is 5,100 just 1.5% below today’s level, so curb your anxiety, but do know that of the 19, 6 have the S&P falling by 10% from today’s level by year-end. So, you have to ask the question, how will credit hold up against potentially correcting stock markets?

Now, interestingly, none of the 19 surveyed took their estimates down from their December forecasts, and 6 took their estimates up, by an average of 7%. So some of the more bearish sentiment at year-end 2023, has warmed up to risk in this market.

For credit, solid, if unspectacular fundamentals and what should be improving technicals continue to form a constructive backdrop. An overbought equity market only enhances relative value. This environment, which is “good enough for credit,” should keep flows into the asset class positive over the course of the year.

Alright, on to our third Thing, Consumer lenders.

Consumer lenders offer great insight into the broader economy through the cycle—in expansionary periods, loan growth surges, and in slowing periods, loan losses rise. Both are easy to track.

So are stock prices, which should reflect all of that in a forward view. In this period of trying to figure out which landing scenario is likely to play out, we figured now was a good time to have a look at consumer lending stocks.

Not surprisingly, consumer lending stocks for the most part have tracked sentiment shifts over the past year. The sector came under pressure first from heightened concerns of a hard landing post the bank failures last March, and second from the higher for longer worry that was at its peak last October. Then, sentiment turned sharply positive as the Fed pivoted toward rate cuts. In 2024, we’ve seen divergence in the sector.

American Express, bellwether for higher income spending, has outperformed the broader market index considerably, up 22% versus the equal-weighted S&P 500’s 6.1% gain. Full spectrum lenders Synchrony and Ally have outperformed as well, up 14% and 15%, respectively. But when we get to debt consolidators, fintechs, and nonprime-oriented lenders, those lenders where customers’ debt management is more prominent, we see more muted performance. OneMain is up 5%. Lending Club is down 6%. Upstart is down 35%.

So that leaves us here: The well-off continue to spend, confident in their record levels of net worth; Much of the middle class continues to borrow (and spend) because they are secure in their employment prospects and positive growth in real wages; Those with a more tenuous financial situation are self-regulating, i.e., spending and borrowing less, in order to shore up their financial wherewithal. All of this squares up with a soft-landing scenario.

So, there you have it, 3 Things in Credit:

1. Slack. It’s building in the labor and industrial markets. And that’s welcome by the Fed

2. Equity euphoria. A sell-off is generally not good for credit, but in this instance, where it feels like an overdue correction, we don’t’ expect a material repricing of credit

3. Consumer lenders. Shareholders are making a noteworthy distinction.

As always, thanks for joining. And make sure you listen in to our latest episode of our Leading Voices in Credit podcast, featuring Blue Owl Capital’s Co-President, Craig Packer. I'll be on the road next week, enjoy the holiday weekend, and we'll see you in two weeks.